You Need to Look in the Trash

Commit these quotes to memory:

"Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds."
-- Seth Klarman, Margin of Safety

"Be fearful when others are greedy, and be greedy when others are fearful."
-- Warren Buffett, Buy American. I am.

You see, value investing is about paying attention to what you pay for an investment. And because we know fear often drives investors to sell their stocks that have already been pummeled, smart dudes like Klarman and Buffett scour the trash bin for bargains, ignore the consensus sentiment and do their own thinking. With that framework in mind, here are three ideas in beaten down sectors that may warrant further investigation.

Defend your portfolio
Investing in the defense industry has traditionally been a safe move for investors. U.S. defense spending has grown at a compound rate of 9.2% over the last decade. But with massive federal deficits and an American people exhausted by foreign military commitments, the mainstream thinks that this spending spree is toast. The sector is off 13.6% from its April highs, compared to an 8.6% drop for the S&P 500, causing many of its dividend payers to trade at attractive prices. Over this same period, L-3 Communications (NYSE: LLL  ) is down 26.2% and trading at an EV-to-EBITDA multiple of just 6.1 -- well below its five-year average. L-3's business centers on technology and infrastructure and seems less likely to be affected by any slowdown in defense spending than fighter aircraft or vehicle projects. The company has been paying down its debt and has more than $1 billion in the bank.

Dig for value
Since the end of 2009, when natural gas prices were just below $6 per million Btu, prices have steadily fallen and are now below $4. Naturally, natural gas exploration and production companies have felt the pain; as prices drop, the economics of drilling become poorer. Nevertheless, the persistent chatter of the U.S. becoming energy independent and the slow adoption of expensive green energy mean that natural gas is the best viable alternative.

Petrohawk Energy (NYSE: HK  ) operates primarily in the Eagle Ford, Haynesville, and Fayetteville shales and specializes in horizontal drilling. The company's drilling costs are 20% lower than its competitors', and it can break even with gas prices at current lows. Petrohawk has hedged much of its production for 2010 and 2011, but stands to benefit as natural gas prices rise in future years. Down 33% this year, Petrohawk is done raising capital but will continue to sell off noncore assets if it needs more cash to fund its drilling budget.

Who doesn't hate homebuilders?
The mere mention of this sector probably caused most readers to stop reading this article -- but if you're still with me, I'd like to talk about a homebuilder with brains and cash. NVR (NYSE: NVR  ) is a rare breed in its sector; while most homebuilders posted losses in each quarter from 2006 to today, NVR posted only one, a truly impressive feat.

NVR accomplished this by employing a unique business model: It doesn't purchase gobs of land hoping to build on it and sell out. Rather, it buys options on tracts of land and only exercises the options if the market conditions are right. The result? Cash flow in good times and in bad. The company has no debt and has 35% of its market cap in cash. With the first-time homebuyer tax credit now extinct, lousy housing starts and sales numbers may provide an even more attractive buy price for this stud among runts.

One man's trash ...
Defense, energy, and homebuilders -- yuck. Clearly, each of these areas has risks that loom large, and they've paid the price in terms of a share price smack-down. But remember the words of Klarman and Buffett, and don't be afraid to invest against the grain. Do your homework and come to your own conclusions, just as they would, and you can pull your portfolio's returns out of the incinerator.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Bryan Hinmon does not own any of the companies mentioned in this article. While he doesn't endorse literal Dumpster diving, he is a big fan of the investing version to source beaten down ideas. The Fool has a disclosure policy.


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